Mimesis Capital: Inside the Event Horizon, Report # 15
Why is Bitcoin price moving down randomly and suddenly?
A common problem with Bitcoin is that it is “too volatile”.
There is no denying that Bitcoin is a volatile asset. The price action supports this conclusion in nearly all time frames (including minute, hour, daily and yearly).
However, volatility isn’t necessarily a bad thing. Indeed, volatility creates opportunity.
For long periods of time (4+ years), Bitcoin’s volatility has been mostly positive. Using this longer time horizon helps remove the noise and focus on the signal.
Volatility and return can be assessed using what is known as the Sharpe ratio, which measures the risk-adjusted return. The Sharpe ratio is the result of dividing the return on the asset by its risk / volatility over a 4 year HODL period.
Bitcoin’s Sharpe Ratio has been higher than any other asset class throughout its existence. This is one of Wall Street’s most popular financial metrics, and it screams “buy bitcoin” as it shows that the return of holding bitcoin has more than compensated holders for their historical downward volatility.
Big, quick downward movements
Why does Bitcoin have such large, sudden downward price movements? What causes these massive corrections in such a short period of time?
Unlike stocks (stocks), which tend to trade aggressively on earnings days (days when companies’ performance and future forecasts change radically), Bitcoin tends to trade aggressively on seemingly random days.
This strange phenomenon confuses traditional commentators and journalists as they struggle to find news that could have affected the price so drastically.
At some point someone comes up with a possible explanation that is immediately circulated due to confirmation bias.
- “Bitcoin fell 10% due to tax increases in Biden”
- “Bitcoin fell 10% due to a (false) exchange rate inflow of 10,000 BTC”
- “Bitcoin fell 10% as Yellen pushes for a capital gains tax of 80% on crypto” (fake news)
Although a small number of people place buy or sell orders based on one-time news orders, they are likely not the only driver behind the sudden crashes in Bitcoin prices that we regularly observe.
In reality, a lot of people are tweeting and spreading the news that Bitcoin price crashed because of X, simply “fooled by accident”.
Although X can be one of many catalysts, the large downturns are often driven by excessive leverage in the system.
This can confuse some people as by definition there must be a seller for every buyer of a futures or perpetual swap contract. However, the prices of these contracts change due to the market equilibrium between longs and shorts.
For example, a funding rate is calculated to help the exchanges keep the perpetual swap price in line with the spot rate. If general market sentiment lags for a long time, the funding rate likely causes longs to pay shorts every 8 hours. Because of this, bitcoin futures contracts are traded with contango during a bull market.
Unchained Capital’s Parker Lews explains the leverage liquidations well by stating that “Bitcoin eliminates imbalances”.
If Bitcoin offers too many leveraged longs without simultaneous buying pressure on the spot market, the current price may be temporarily unsustainable.
As @WClementeIII explained, an overfunded market resembles a Jenga tower built on a fragile base. If the refinancing rates and the futures contango are extremely high without any significant buying pressure on the spot market, the Jenga tower only needs to be pushed lightly before it collapses.
These leverage liquidations create an ugly negative feedback loop:
- Price falls.
- Highly indebted longs are liquidated (forced sellers).
- The price keeps falling.
- Longs with lower leverage are liquidated (more forced sellers).
- Traders see falling prices and jump on the trend.
- Price falls.
- Repeat this process until the vulnerability to systemic leverage is eliminated.
This imbalance, caused by excessive leverage, leads to volatility. This volatility causes coins to be transferred from weak hands to strong hands that understand Bitcoin. After selling weak hands, the price has to adjust to the new equilibrium.
A new base of strongholders is then built at a more sustainable price level, and then Bitcoin’s parabolic bull run continues as it has for more than a decade. This is all due to the fact that, due to their superior monetary properties, individual games theoretically converge on Bitcoin as the Schelling point.
Some may wonder if excessive leverage is a primary reason for these sudden price movements. How can the futures curve be good for Bitcoin, especially when the curve is being driven by demand for leveraged long Bitcoin purchases?
First, contango base trading still persists, and it is profitable for a low risk USD trader to buy spot, sell futures, and capture the spread. However, if the curve gets too high without enough capital coming in to execute the base trade or purchase on the ground, the contango / finance rate may not get sustained high.
If the refinancing rate or the contango curve gets too high without significant buying pressure in the spot market driving up the price, the price could be driven on a fragile basis by leveraged longs paying high refinancing rates. In this case, it could potentially result in a violent crash.
This is a guest post from Mimesis Capital. The opinions expressed are solely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.